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1
Consumer choice and demand decisions
2
Four key elements in consumer choice

• Consumers income
• Prices of goods
• Consumer preferences
• The assumption that consumers maximise utility

3
Background

• Marginal Utility Theory

4
MARGINAL UTILITY THEORY

• Total and marginal utility
• meaning of total utility
• marginal utility ?TU/?Q
• diminishing marginal utility
• total and marginal utility curves

5
Darrens utility from consuming crisps (daily)
Packets of crisps
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
Packets of crisps consumed (per day)
6
Darrens utility from consuming crisps (daily)
TU
Packets of crisps
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
Packets of crisps consumed (per day)
7
Darrens utility from consuming crisps (daily)
TU
Packets of crisps
TU in utils
MU in utils
- 7 4 2 1 0 -1
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
Packets of crisps consumed (per day)
8
Darrens utility from consuming crisps (daily)
TU
Packets of crisps
TU in utils
MU in utils
- 7 4 2 1 0 -1
0 1 2 3 4 5 6
0 7 11 13 14 14 13
Utility (utils)
MU
Packets of crisps consumed (per day)
9
Darrens utility from consuming crisps (daily)
TU
Utility (utils)
MU
Packets of crisps consumed (per day)
10
Darrens utility from consuming crisps (daily)
TU
DTU 2
DQ 1
Utility (utils)
MU DTU / DQ 2/1 2
MU
Packets of crisps consumed (per day)
11
Deriving an individual persons demand curve
MU, P
MU D
O
Q
12
Deriving an individual persons demand curve
MU, P
a
P1
MU D
O
Q1
Q
13
Deriving an individual persons demand curve
MU, P
a
P1
b
P2
MU D
Q2
O
Q1
Q
14
MARGINAL UTILITY THEORY

• Limitations of the one-commodity version
• marginal utility affected by consumption of other
  goods
• marginal utility of money not constant
• Optimum combination of goods
• the equi-marginal principle
• MUA/MUB PA/PB
• deriving a demand curve

15
Consumer choice and demand decisions

• Indifference Analysis

16
Assumptions

• Consumers can rank their preferences
• Consumers prefer more to less

17
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve

18
Constructing an indifference curve
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Combinations of pears and oranges that Clive
likes the same amount as 10 pears and 13 oranges
19
Constructing an indifference curve
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
20
Constructing an indifference curve
a
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
21
Constructing an indifference curve
a
Pears
Point
Oranges
b
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
22
Constructing an indifference curve
a
Pears
Point
Oranges
b
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
c
Pears
d
e
f
g
Oranges
23
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution

24
Deriving the marginal rate of substitution (MRS)
MRS 4
DY 4
MRS ?Y/?X
Units of good Y
Units of good X
25
Deriving the marginal rate of substitution (MRS)
a
MRS 4
DY 4
b
26
MRS ?Y/?X
DX 1
Units of good Y
MRS 1
d
DY 1
6
7
Units of good X
26
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution
• an indifference map

27
An indifference map
The further out the curve, the higher the level
of utility
Units of good Y
An indifference curve shows all combinations of X
and Y that give a particular level of utility.
Units of good X
28
The impossibility of two indifference curves
crossing
A consumer cannot be indifferent between a and
both b and c
Units of good Y
I1
Units of good X
29
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution
• an indifference map
• The budget line
• constructing a budget line

30
A budget line
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
Assumptions PX 2 PY 1 Budget 30
31
A budget line
a
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
Units of good Y
Assumptions PX 2 PY 1 Budget 30
Units of good X
32
A budget line
a
Point on budget line a b
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
Assumptions PX 2 PY 1 Budget 30
Units of good X
33
A budget line
a
Point on budget line a b c
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
c
Assumptions PX 2 PY 1 Budget 30
Units of good X
34
A budget line
a
Point on budget line a b c d
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
c
Assumptions PX 2 PY 1 Budget 30
d
Units of good X
35
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution
• an indifference map
• The budget line
• constructing a budget line
• effect of a change in income

36
Effect of an increase in income on the budget line
Units of good Y
Units of good X
37
Effect of an increase in income on the budget line
Units of good Y
Budget 40
Budget 30
Units of good X
38
INDIFFERENCE ANALYSIS

• Indifference curves
• constructing an indifference curve
• the shape of an indifference curve
• diminishing marginal rate of substitution
• an indifference map
• The budget line
• constructing a budget line
• effect of a change in income
• effect of a change in price

39
Effect on the budget line of a fall in the price
of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
Units of good X
40
Effect on the budget line of a fall in the price
of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
Units of good X
41
Effect on the budget line of a fall in the price
of good X
Assumptions PX 1 PY 1 Budget 30
Units of good Y
Units of good X
42
Effect on the budget line of a fall in the price
of good X
a
Assumptions PX 1 PY 1 Budget 30
Units of good Y
B2
B1
c
b
Units of good X
43
INDIFFERENCE ANALYSIS

• The optimum consumption point

44
Finding the optimum consumption
Units of good Y
O
Units of good X
45
Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
46
Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
47
Finding the optimum consumption
Points r, s, u and v give a lower level of
utility than point t.
Point t gives the maximum level of utility
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
48
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB

49
Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
50
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB
• The effect of a change in income

51
INDIFFERENCE ANALYSIS

• The optimum consumption point
• equating the marginal rate of substitution with
  the price ratio
• MRS MUA/MUB PA/PB
• The effect of a change in income
• the incomeexpansion path

52
Effect on consumption of a change in income
Units of good Y
B1
I1
O
Units of good X
53
Effect on consumption of a change in income
Units of good Y
I2
B2
B1
I1
O
Units of good X
54
Effect on consumption of a change in income
Units of good Y
I4
I3
I2
B2
B3
B1
B4
I1
O
Units of good X
55
Effect on consumption of a change in income
Income-expansion path
Units of good Y
I4
I3
I2
B2
B3
B1
B4
I1
O
Units of good X
56
Effect of a rise in income on the demand for an
inferior good
Units of good Y (normal good)
I1
B1
O
Units of good X (inferior good)
57
Effect of a rise in income on the demand for an
inferior good
Units of good Y (normal good)
I2
a
I1
B1
B2
O
Units of good X (inferior good)
58
Effect of a rise in income on the demand for an
inferior good
Income-expansion path
b
The incomeexpansion path shows how consumption
varies with income.
Units of good Y (normal good)
I2
a
I1
B1
B2
O
Units of good X (inferior good)
59
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceexpansion path

60
Effect of a fall in the price of good X
Units of good Y
Units of good X
61
Effect of a fall in the price of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
B1
Units of good X
62
Effect of a fall in the price of good X
Assumptions PX 1 PY 1 Budget 30
Units of good Y
j
B1
Units of good X
63
Effect of a fall in the price of good X
a
Assumptions PX 1 PY 1 Budget 30
Units of good Y
j
I1
B1
B2
Units of good X
64
Effect of a fall in the price of good X
a
The priceexpansion path shows how consumption is
affected by a change in the price of one of the
two goods
Units of good Y
j
I1
B1
B2
Units of good X
65
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceexpansion path
• deriving the individual's demand curve

66
Deriving a demand curve from a price-expansion
path
As the price of X falls, so the budget line
swings outwards.
Expenditure on all other goods
B1
Units of good X
67
Deriving a demand curve from a price-expansion
path
Fall in the price of X
a
Expenditure on all other goods
I1
B1
Units of good X
68
Deriving a demand curve from a price-expansion
path
a
Expenditure on all other goods
I1
B1
Units of good X
69
Deriving a demand curve from a price-expansion
path
a
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
70
Deriving a demand curve from a price- expansion
path
a
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
71
Deriving a demand curve from a price-consumption
curve
a
Price-consumption curve
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
Price of good X
Q1
Units of good X
72
Deriving a demand curve from a price-consumption
curve
a
Price-consumption curve
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
a
P1
Price of good X
Q1
Q2
Units of good X
73
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceexpansion path
• deriving the individual's demand curve
• Income and substitution effects of a price change

74
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceexpansion path
• deriving the individual's demand curve
• Income and substitution effects of a price change
• a normal good

75
Income and substitution effects normal good
Units of good Y
I1
I2
I3
I4
I5
I6
QX1
Units of Good X
76
Income and substitution effects normal good
Rise in the price of good X
Units of good Y
f
I1
I2
I3
I4
I5
B1
I6
QX3
QX1
Units of Good X
77
Income and substitution effects normal good
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1
I6
QX3
QX1
QX2
Units of Good X
78
Income and substitution effects normal good
g
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1a
B1
I6
QX3
QX1
QX2
Units of Good X
Substitution effect
79
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceexpansion path
• deriving the individual's demand curve
• Income and substitution effects of a price change
• a normal good
• an inferior good

80
Income and substitution effects Inferior
(non-Giffen) good
Units of good Y
I1
I2
QX1
Units of Good X
81
Income and substitution effects Inferior
(non-Giffen) good
Rise in the price of good X
Units of good Y
f
I1
I2
B1
QX3
QX1
Units of Good X
82
Income and substitution effects Inferior
(non-Giffen) good
Units of good Y
f
h
I1
I2
B1
B2
QX1
QX2
Units of Good X
83
Income and substitution effects Inferior
(non-Giffen) good
g
A positive income effect a rise in price
partially offsetting the fall in consumption.
Units of good Y
f
h
I1
I2
B1
B2
B1a
QX3
QX1
QX2
Substitution effect
Units of Good X
84
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceexpansion path
• deriving the individual's demand curve
• Income and substitution effects of a price change
• a normal good
• an inferior good
• a Giffen good (a special type of inferior good)

85
Income and substitution effects Giffen good
Units of good Y
I1
I2
QX1
Units of Good X
86
Income and substitution effects Giffen good
Rise in the price of good X
f
Units of good Y
I1
B1
I2
QX3
QX1
Units of Good X
87
Income and substitution effects Giffen good
f
Units of good Y
I1
h
B1
B2
I2
QX3
QX1
QX2
Units of Good X
88
Income and substitution effects Giffen good
g
f
Units of good Y
A positive income effect that is bigger than the
negative substitution effect. A rise in price
causes a rise in consumption.
I1
h
B1a
B1
B2
I2
QX3
QX1
QX2
Units of Good X
Substitution effect